Wednesday, September 28, 2011

On structuring lease concessions

The Hindu reports of a concession agreement signed between the Andhra Pradesh Tourism Development Corporation (APTDC) and a private hotel operator, Amogh Group of Hotels, for leasing out one of APTDC's centrally located Tourism complex in Hyderabad. Under the 15 year lease, terms of which have been arrived at through an open competitive bidding process, the private operator will be allowed to run the 84 room complex as a three-star hotel. The operator will pay Rs 23 lakh per month as rental fee and also provide 20 rooms to the state General Administration Department (GAD) for accommodating state guests.

This apparently simple lease agreement could be the setting for a simple thought experiment. The APTDC and state government's desired objectives are two-fold - accessing 20 rooms for the GAD, while maximizing the lease rental. There are two possible approaches to achieve this objective. One, as the APTDC has done, is to clearly state upfront the 20 room GAD requirement and then invite hotel operators to quote on the lease rental. Alternatively, treat the two as separate requirements and then let the private operator quote a lease rental for the entire hotel. Subsequently, the 20 rooms can be leased in either on mutually agreeable terms from the the same operator or a separate tender can be called for leasing in 20 rooms from any private hotel across the city.

Which of the two approaches is likely to be more beneficial - generate higher net returns - for the state government? An examination of the incentives and option values that bidders face would be illuminating.

In the first case, the operator factors in the costs and benefits of already having committed the 20 rooms. At a cognitive level, he has made two trade-offs - one on the lease rental amount for the 64 rooms and another on the lease amount that he sets-off against the 20 rooms. I am inclined to believe that he makes them as two separate decisions, under-weighting (or minimizing the rent pay-out) the first and over-weighting (maximizing the rent receipt) the second. There is also the option value he attaches to having foreclosed the option of retaining all the 84 rooms. In other words, there are atleast three factors that influences his decision, all of them having the effect of working towards keeping down the lease rental payout to the government. The multiplicity of incentive factors, all working separately, distorts the decision-making environment and each works towards bidding down the quotes.

In the second case, the operator is primed into bidding for the entire property and retains the option of whether to give or not give the 20 rooms. To that extent, the option value is discounted in the bid. There is considerable clarity in the bidding environment. The only factor working in the bidder's mind is to get the best possible deal on the lease rental. In this case, the competition between bidders will work towards keeping all the bidders honest.

After the hotel, with all rooms, is bidded out, the government could negotiate and seek mutually agreeable lease terms. Alternatively, it could call tenders for leasing in 20 rooms from any existing hotel, within certain areas of the city. Either way, more so with the second approach, there would be more efficient price discovery with respect to the lease rental for the GAD rooms. It is possible that there are certain private hotel operators who would want to use the signal of government business to improve their hotel business itself and would therefore quote at a discount.